If the traditional fixed income indices like the Barclays U.S. Aggregate Index or the IBoxx US Dollar Investment Grade Corporate Bond Index are no longer the ideal fixed income investments for the next cycle, then what exposures should investors consider as alternatives?
Investors may want to look to reposition their fixed income portfolios toward vehicles with the potential for less interest rate risk, less Treasury, MBS, and lower rated general obligation municipal bond exposure and greater corporate bond exposure. These vehicles may include senior secured loans, short-term high yield bonds, short-term investment grade bonds, short-term municipal bonds, floating rate notes and crossover bonds.
SENIOR SECURED LOANS
Why: Senior loans are floating rate bank loans made to below investment grade companies. As such, these investments provide corporate credit exposure with limited interest rate duration. Like high yield bonds, senior loans have the potential to offer an attractive yield, but unlike high yield bonds, senior loans have minimal duration, as they are floating rate instruments whose interest rates reset every three months. In a rising rate environment, investors could potentially benefit from higher interest payments. In addition, since loans are senior in the capital structure they have the priority claim in the event of a default and are potentially less risky than bonds issued from the same company.
How: Since senior loans are a relatively inefficient asset class, investors could potentially benefit from an actively managed investment approach. An actively managed approach allows for the acquisition of loans in the primary market, may identify and sell loans that are likely to be removed from an index due to credit events and can over and underweight individual loans.
SHORT-TERM HIGH YIELD BONDS
Why: For investors looking for the competitive income offered by below-investment grade securities, but wary of interest rate risk in a rising rate environment, short duration high yield bonds may be an attractive option. The 0–5 year maturity window offers half of the interest rate risk of longer maturity bonds with the potential benefit of less performance volatility.
How: While high yield is a market segment with generally low duration, short-term high yield offers a more attractive yield per unit of duration. More specifically, the Barclays U.S. High Yield $350 MM Cash Pay 0–5 Year 2% Capped Index has a modified duration of 2.08 versus 4.34 for the Barclays Very Liquid High Yield Index. As a strategic holding employed to lower overall portfolio duration, short duration high yield can be a valuable complement to longer maturity funds within a portfolio’s high yield allocation.
SHORT-TERM INVESTMENT GRADE BONDS
Why: Shorter duration bonds allow for greater protection in an environment of rising rates and for quicker reinvestment at potentially higher yields. Compared with longer-term bonds, short-duration investment grade bonds may benefit earlier from increased income from the fund’s underlying bonds in a rising rate environment.
How: Moving a portion of a portfolio’s fixed income allocation to shorter duration funds can shorten overall portfolio duration, decreasing sensitivity to the negative effects of rising long-term rates. However, investors may wish to focus on corporate issues and avoid exposure to government-related sectors that are either highly leveraged or low yielding, which can be found in more traditional credit exposures.
SHORT-TERM MUNICIPAL BONDS
Why: Many municipal bonds offer yields that are greater than those on comparable maturity Treasury bonds which is rare as municipal bonds offer tax exempt interest. Investors in higher tax brackets can add a historically attractive yield spread over US Treasury investments.
How: Within the muni market it pays to be selective with exposures, especially when considering the amount of idiosyncratic risks, such as Detroit, MI and Puerto Rico. The Barclays Managed Money Municipal Short Term Index is comprised of 1 to 5-year municipal bonds rated Aa3/AA- or higher by ratings agencies.
FLOATING RATE NOTES
Why: As part of a portfolio’s fixed income allocation, floating rate notes can be used to shorten overall portfolio duration and prepare for a rising rate environment. As the Fed looks to taper its monthly bond purchases, an allocation to these notes can shorten overall portfolio duration, decreasing sensitivity to the negative effects of rising long-term rates. In addition, as the Fed ultimately begins to raise the short-term Fed Funds rate—which it has projected it will do in 2015—investors in floating rate notes may potentially see increased income from the fund’s underlying bonds due to increases in 3-month LIBOR rates.
How: Floating rate notes are variable rate bonds with minimal duration. Their coupon rates reset on a regular basis, based on a specific index, such as 3-month LIBOR. Floating rate notes provide exposure to these bonds issued to US corporations and floating rate, dollar-denominated issues of non-US corporations, governments and supranational entities.
CROSSOVER BONDS
Why: While lower rated issues generate outsized returns over certain periods, they do so with significantly greater volatility than higher rated bonds—the main reason being that lower rated bonds tend to default with much greater frequency than higher rated bonds. Crossover bonds have less credit risk than many high yield bonds, yet generally offer higher yields than most investment grade bonds.
In addition, because higher yielding corporate bonds tend to have shorter maturities, crossovers may have less sensitivity to interest rate changes (i.e., lower duration) than higher rated bonds.
How: The BofA Merrill Lynch US Diversified Crossover Corporate Index is comprised of an approximately 50%/50% split between BBB-and BB-rated bonds. This targets the portion of the US corporate bond market that has historically offered the best risk-adjusted returns as measured by Sharpe ratios.
ULTRA SHORT-TERM BONDS
Why: Ultra short-term bond funds typically invest in a portfolio of fixed income securities targeting a fund duration of one year or less. Additionally, most ultra short-term bond funds invest in high quality securities such as treasuries, and highly rated corporate and asset-backed bonds. Because of the short duration and high quality nature of the portfolios, there is less likelihood of price fluctuations than funds focused on longer duration and/or lower-rated fixed income securities.
How: Allocating to an ultra short-term bond fund, such as ULST, can shorten overall portfolio duration, decreasing sensitivity to the negative effects of rising long-term rates. Acting as a portfolio diversifier, ultra short term bonds also have low correlations to other asset classes, seek to provide downside protection and can be a source of immediate to intermediate liquidity.
ETF Trends note: This information is part of the whitepaper “A Blank Slate: Fixed Income for the Next Cycle” by State Street Global Advisors.